James Rundle: Doubling Up and Doubling Down

Any discussion about the derivatives markets these days tends to center on swap execution facilities (SEFs). The darling of over-the-counter (OTC) reform, SEFs provide a platform for the execution and clearing of standardized derivative contracts, aimed at reducing systemic risks and providing transparency for a typically opaque market. The reasons behind them are easy enough to understand, as the moss starts growing on Lehman Brothers’ tombstone, and JPMorgan continues to weather its extended hangover from the Bear Sterns acquisition.

SEFs certainly have the markets talking: Everything from SEF aggregation to connectivity is being discussed and dissected, although market participants and analysts are undecided as to whether they will even see the light of day before the US Commodity Futures Trading Commission (CFTC) officially authorizes them.

“Some people are saying that SEFs may never really happen,” says Ganesh Iyer, senior product marketing manager at IPC Systems. “Because you could trade on any other exchange that’s open for trading swaps, as well as on designated contract markets (DCMs), which do the same job as a SEF.”

The sections of Iyer’s clients at IPC who are raising these concerns aren’t the only ones. Last year, Tabb Group published a paper by Adam Sussman, partner and director of research at the consultancy, titled The Death of a SEF: The Coroner’s Report. In the document, Sussman posited that a DCM has an advantage over a SEF due to the fact that the latter is closer to an alternative trading system than an exchange, but still has the same regulatory oversight as a primary market does, with a smaller slice of the pie. Furthermore, DCMs already function within known boundaries, having been allowed to operate since the 1930s with the passing of the Commodity Exchange Act, while SEFs are still suffering from regulatory uncertainty. The Dodd–Frank Act, which created SEFs, provides DCMs with the ability to trade swaps as well as futures and options.

Six of One
The regulatory point is a particularly relevant one. A recent survey by IPC found that across its buy-side and sell-side respondents, only 19 percent thought that these firms were wholly prepared to engage in the new OTC regulatory regime. The lack of clarity from regulators around this area was a key reason driving this feedback. Likewise, the ongoing “futurization” of swaps, which aims to mimic the liquidity and cash-flow attributes of futures, fits well alongside the DCM model.

Market participants and analysts are undecided as to whether SEFs will even see the light of day.

The CFTC has called for a public discussion to focus on this very issue. However, interest in SEF registration has hardly diminished. Over 50 institutions, including big names such as Bloomberg, Tradeweb and others have indicated that they intend to submit their software and processes once the CFTC opens registration. Some trades are already being conducted in a SEF-like manner ahead of time.

Half-a-Dozen of the Other
Regardless of whether SEFs or DCMs emerge as the front runners, the technology behind both is broadly similar: They will require pre-trade credit checking functionality, risk management, reporting and data-recording facilities, among other areas. Sell-side institutions, rather than buy-side firms, will bear the overwhelming majority of the technology burden, as well as aggregation and order-routing functionality.

Rules such as displaying quotes in open markets for a designated amount of time, or sending out bids to multiple entities in order to guarantee best execution will also ensure a high degree of correlation and interconnectivity between institutions, SEFs, buy-side firms and brokers. Some are questioning whether or not SEFs may as well put in the extra mile and become DCMs, while others consign that to the internal affairs department.

Whatever the case, technology investment for the sell side continues unabated in a new era of derivatives trading.